Having a glance at the total debt + unfunded liabilities US has, producing its way out of debt is out of question. If it is option b) which is default, it means extreme levels of austerity, much much more severe then we are seeing in Greece. Expecting this level of honesty from US, to bear extreme pain, to repay debt, is simply insane. The whole nation will erupt in violent revolution and no govt has the guts to accept it. Infact that situation has to happen eventually until the crisis is pushed to a point beyond which it can not be pushed any further. How the crisis is pushed further, we will see it in 3rd point.

The 3rd and the most convenient way is inflation, which means devalue your currency and print more money to get out of debt. This suits the borrower if it is the issuer of the currency in which debt is taken. But the creditor is going to suffer because he will get the money back with REDUCED PURCHASING POWER.

Let me quote what our own RBI says about Rupee denominated debt, in “India’s External Debt, A Status Report 2009-10”, (page 11) … “Unlike foreign currency denominated debt, where the currency risk is borne by the borrower, the characteristic feature of domestic currency denominated debt is that the exchange risk is borne by the creditor. The contractual liability, however, is settled in terms of the designated foreign currency (through exports in case of Rupee debt owed to Russia).This implies that the borrower gains (and the creditor loses) when the local currency depreciates since less has to be repaid in foreign currency terms and vice versa.”.

So we clearly see that central banks knows fully well that if they are the issuer of the currency in which debt exists, they can devalue and pay less. And that is what we have been seeing federal reserve doing all these decades, while at the same time accumulating more debt. The reason was that US was having the unique advantage of being the issuer of world’s reserve currency and they were exploiting this position. Therefore I believe that US will continue to inflate to get out of debt. Falling dollar means, China as a creditor in dollar denominated debt looses the value of its money anyway even if it does not do anything.

Understanding this risk of loosing value of its dollar investments, China offlate has been aggressively trying to diversify. But thats where it gets trapped in the web, because to ensure that its dollar investments do not loose value China has to continue to invest in US treasuries so that US doesn’t have to do quantitative easing and devalue its dollar. Since US is the biggest market for China, later has to continue to work and provide more goods to US to get dollars to be invested in US treasuries. So effectively goods provided by China is filling up the supply gap caused due to massive dollar printing by US. Now the trap here is that if China does not invest in US treasuries, quantitative easing will be required resulting in more dollar devaluation thereby loss of Chinese investments. Since the US deficits are growing exponentially, China will have to do greater investment in US treasuries, to save dollar value. To do this greater investment, China will need to supply more goods to US (so that it gets more money to invest). So basically to get back its money from US, China has to lend them more. The pace with which China reduces the investment in treasuries, dollar devaluation will increase (because of quantitative easing). On the other hand, if China increases the investment in US treasuries to save dollar value, inflation in China will increase causing civil unrest, thereby destabilising the government. The situation as it stands today is that, thanks to trillions of dollars worth deficit US has, despite of Chinese investments the debt requirements are growing exponentially, requiring massive quantitative easing and thereby causing dollar devaluation. To help dollar retain its value, China so far has been devaluing its currency almost at the same pace but it can not do so without threatening its internal political stability as the inflation is breaking all records and causing civil unrest. China will have to quit dollar when the cost of saving dollar (inflation) will start to threaten the national stability itself. Infact China will also see that despite of their sufferings of inflation, US deficits are growing exponentially causing greater dollar devaluation and therefore making their efforts futile, to save their dollar investments’ value.

Some people argues that in the absence of other currency alternative dollar will not crash. They say that Euro, GBP and almost all major currencies are falling. Yuan and Yen both are deliberately devalued to maintain the exchange rate with dollar. So there is no alternative to dollar and therefore it will not crash. The point these people miss in their assessment is that what is the purpose of currency? Why does one holds the currency? Only to buy commodities. If the currency is fast loosing value, people will instead of holding currency will start holding the commodity. So investors will start diversifying its investments from currency to commodity because currency is loosing its function “store of value”.

Here we are talking about China particularly and same principle applies to them. When they will realise that to hold dollars they are actually investing more (providing debt to US) and in turn getting negative returns (loosing money to dollar devaluation), they will definitely aggressively offload dollars which will create a panic in the currency market and global economy. This will result in inflation which actually means prices of commodity in terms of currency will go very high.

WHEN THE BETTER SENSE PREVAILS UPON CHINA, the unthinkable will happen and IT WILL DUMP THE TREASURIES. Gold will be the real money as nobody will trust currencies. China and US both will blame each other and the likes of Marc Faber are not wrong in saying that there may be War. I see a serious US vs China war / conflict whatever you want to say, as a strong possibility. And I strongly believe that Arab’s will support China because they also have huge investments in dollars. The clock is ticking for the OPEC / China to pull the trigger…